The prepaid business, long an engine of growth for the wireless industry, is starting to sputter.

TracFone, MetroPCS, and Leap Wireless all reported disappointing second-quarter financial results. The period is typically weaker for the prepaid providers as the business takes a breather following two consecutive quarters of growth.

But their performance fell below even the lowered expectations placed on them, underscoring the pressures that the companies face with intense price competition and a still weak economic environment. Furthermore, some of the companies warned of a weaker third quarter, leading some to wonder if the prepaid business is poised for slower growth over the long run, and not just suffering from a short-term hiccup.

"Obviously, they had that explosive growth for a while," said Fedor Smith, an analyst at research firm Atlantic-ACM. "That's coming to an end."

While the recession had initially driven customers with service contracts into the arms of prepaid providers, the continued sluggishness and high rate of unemployment is starting to take its toll on the companies. What was an early benefit has become a drag, since prepaid customers are the most economically sensitive.

TracFone, a unit of America Movil, added 236,000 net customers in the period, a significant drop from the first quarter and year-earlier period. MetroPCS added 199,000 net new customers, or more than 50,000 short of what Wall Street had expected. Leap, which sells its service under the Cricket brand, lost 103,000 customers, even as analysts had expected a small gain in the period.

The common thread: a surprisingly high customer turnover rate. Analysts point to competition from an even lower end service, Assurance Wireless, which is a government-subsidized offering only available to low-income families. Unsurprisingly, Assurance's parent, Sprint Nextel, reported robust prepaid growth, adding 674,000 net prepaid customers--1.1 million if you exclude defections from its iDEN network.

Despite disappointing numbers, the companies remained upbeat. MetroPCS maintained that its strategy of adding smartphone and family plan customers would lead to a decline in its turnover rate, also known as churn. The thinking is that consumers who would spend more on a pricier smartphone are less likely to leave the service. Likewise, individuals in a family plan are reluctant to leave unless all of the members agree.

Chief Operating Officer Thomas Keys said that 38 percent of its customers were on a family plan and a quarter owned smartphones.

"We don't think we have any substantial issues right now on churn," he said during a conference call yesterday. "It's been rewarding to watch as we moved into July and watched that build. Certainly as of today's call, we're seeing trend lines that make us comfortable."

Despite the weakest customer performance of the bunch, analysts seemed to be the most optimistic of Leap's near-term prospects.

TracFone, meanwhile, blamed the weakness on the seasonal downturn, but also acknowledged a higher turnover rate.

The pressures are two-fold. At the high-end of the prepaid range, where customers are spending more for smartphones, MetroPCS and Leap are getting outflanked by T-Mobile USA, which, despite its struggles, has still been able to add prepaid customers. It said today that it had signed up a net 231,000 such customers, despite larger losses on the contract end. T-Moblie recently cut its data plans, offers a no-contract option, and offers a more attractive line-up of smartphones.

Further up the spectrum, Smith said the $49 iPhone 3GS has also enticed customers who normally would have gone with a prepaid plan.

And while smartphones have helped the prepaid players stay competitive, they haven't resulted in the kind of revenue improvement and customer loyalty that Wall Street was expecting.

"The belief that increasing smartphone penetration should drive higher (average revenue per user) and lower churn has at least been temporarily torpedoed by the MetroPCS commentary," said William Power, an analyst at Robert W. Baird & Co. He downgraded both MetroPCS and Leap's stocks.

On the low end, Assurance is posing a larger competitive threat to the prepaid providers. As unemployment continues to be high, more people are qualifying for the low-income wireless lifeline service. That's been a boon to Sprint, but at a cost to the likes of MetroPCS, and even TracFone, which is known for serving the lowest end of the prepaid market. Those consumers who a few years ago couldn't afford a pricier service contract now can no longer afford even prepaid service.

The third quarter is expected to be another rough one, as seasonal weakness weighs on the different companies. The big test for the industry's resiliency will be in the fourth quarter, which is typically strong.

But with so much uncertainty, few are willing to call a major rebound.

About the author

Roger Cheng is the executive editor in charge of breaking news for CNET News. Prior to this, he was on the telecommunications beat and wrote for Dow Jones Newswires and The Wall Street Journal for nearly a decade. He's a devoted Trojan alum and Los Angeles Lakers fan.
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